How To Determine The True Price of ETFs

April 10, 2013

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The following article originally appeared in Morningstar Advisor

Although there are a number of
considerations to make in investing, chief among them is cost. Within the land
of exchange-traded funds, the traditional view of cost can be summarized with
two words: expense ratio. Generally, the expense ratio is a good yardstick of
an ETF’s price. There are, however, a number of intangibles that, while
frequently overlooked, present the investor with very real costs. Here’s how to
find these sneaky expenses.

1 Reframe the Question

When considering ETF costs, don’t merely
ask what they charge. Instead, ask yourself what you expect to receive and
whether or not the product has provided it historically. The incidence of
negative excess of return, for example, can represent a sizable cost relative
to the expense ratio.

2 Find Any Persistent Negative Excess Return

Most ETFs are index vehicles, and
ideally, these funds should track their index, less the expense ratio.
Morningstar’s proprietary data point Estimated Holding Cost, found in most of
our products, measures the gap in return between the ETF and the index. In
addition to the expense ratio, it captures the realized cost of replicating an
index. Indexes with high turnover or relatively illiquid constituents can be
more costly to replicate. For funds that track these types of indexes, we would
expect the estimated holding cost to be higher than the expense ratio.

Take two funds tracking very similar indexes,
the Dow Jones U.S. Total Stock Market and the Dow Jones U.S. Index. They are
tracked by SPDR Dow Jones Total Market TMW and iShares Dow Jones U.S. Index
IYY, respectively. Given the similarity between the benchmarks, investors could
use either to gain the same exposure. They maintain a correlation of 1.00 over
the past three years. Both funds charge exactly 20 basis points per annum.
Through midyear, IYY returned 7 basis points less than the index. The tracking
error falls close to the size of the product’s annual fee. The SPDR product,
however, has trailed its index by a larger 18 basis points.

We can attribute this additional lag to
the fact that the SPDR fund is tracking a total market index, which includes
all U.S. securities available to investors, 3,718 securities in total. The
iShares fund tracks an index that includes only the top 95% of the available
market cap, amounting to a total of only 1,340 securities. In other words, we
think the reason for the SPDR fund’s greater lag to the index is due to the
fact that small-cap stocks are harder to track, given their lower liquidity.

Generally speaking, then, the gap in
return between the ETF and the index can be thought of as an additional cost.
These figures, however, will fluctuate from year to year and sometimes can even
be positive. Significant and persistent deviations from expected levels of
excess return should raise eyebrows. A good way to gauge the potential for
deviation from the index is the data point Tracking Volatility, which measures
the volatility of the excess return figure over time. Again, given TMW’s
greater exposure to small caps, we would expect this fund to have a higher
Tracking Volatility figure relative to the iShares fund. As such, investors
looking for the best index-tracking ETF would be better off in the iShares
fund. Those who are more bullish on small caps and want that exposure can pick
the SPDR fund, the trade-off being that this ETF won’t track as well as the
iShares product.

3 Consider Impact of Your Own Trading Activity

A second intangible cost comes by virtue
of a product’s liquidity. Illiquid markets provide for very serious
implications for investors. Say you would like to purchase 10 shares of ETF XYZ
at $5 per share, but to fill this order immediately, you had to purchase half
of the order at $6. Assuming no transaction fees, you spent a total $55 to
acquire 10 shares. Had you expected to fill this entire order at the initial $5
level, the trade cost you 10% more than you expected it to. This exemplifies
the idea that market illiquidity can pose a real cost.

While there are sophisticated statistical metrics that can be used to
gauge and project market impact cost, volume can serve as a decent proxy for
liquidity. Trading in ETFs that maintain higher average daily trading volume
numbers will leave you far less exposed to suffering these market impact costs.

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